QFC Financial Engineering & Structured Products 2

Question 1

What is 'prepayment risk' in the context of mortgage-backed securities (MBS)?

Accepted Answer

The risk that borrowers repay mortgages faster than expected, forcing reinvestment at lower rates

Answer

The risk that borrowers default on their mortgage obligations

Answer

The risk that interest rates rise, reducing the MBS market price

Answer

The risk that the servicer fails to remit payments to MBS investors

Question 2

What is a Collateralized Mortgage Obligation (CMO) and why was it created?

Accepted Answer

A structured MBS that redistributes prepayment risk across multiple maturity tranches

Answer

A government guarantee extended to all classes of mortgage-backed securities

Answer

An insurance contract that protects investors against homeowner default losses

Answer

A floating-rate instrument backed exclusively by adjustable-rate mortgages

Question 3

What distinguishes 'agency MBS' from 'non-agency MBS'?

Accepted Answer

Agency MBS carry an explicit or implicit government guarantee; non-agency MBS do not

Answer

Agency MBS are backed by commercial mortgages; non-agency MBS by residential mortgages

Answer

Agency MBS use active portfolio management; non-agency MBS are passively managed

Answer

Agency MBS are restricted to institutional investors; non-agency MBS are retail products

Question 4

In MBS analysis, what does the Conditional Prepayment Rate (CPR) measure?

Accepted Answer

The annualized fraction of the remaining mortgage pool that is prepaid in a given period

Answer

The probability that an individual borrower will default in a given month

Answer

The ratio of cumulative credit losses to the original pool balance

Answer

The price sensitivity of an MBS to a parallel shift in interest rates

Question 5

What causes 'negative convexity' in mortgage-backed securities?

Accepted Answer

MBS price appreciation slows as rates fall because accelerating prepayments shorten duration

Answer

MBS prices decline faster than duration-adjusted predictions when rates rise sharply

Answer

The yield spread on MBS widens when interest rate volatility increases

Answer

MBS lose market value when the Treasury yield curve inverts

Question 6

What is an Interest-Only (IO) strip created from mortgage cash flows?

Accepted Answer

A tranche that receives only the interest portion of the underlying mortgage payments

Answer

A tranche that receives only scheduled principal repayments from the mortgage pool

Answer

A zero-coupon bond formed by stripping the coupon from a Treasury bond

Answer

A floating-rate CMO tranche whose coupon resets monthly based on short-term rates

Question 7

What is 'extension risk' in mortgage-backed securities?

Accepted Answer

The risk that rising interest rates slow prepayments, extending the MBS's effective duration

Answer

The risk that MBS maturity extends due to collateral substitution by the servicer

Answer

The risk that the originator adds lower-quality mortgages to the pool after issuance

Answer

The risk that credit losses extend beyond junior tranches into senior MBS classes